Smith’s Troubles Blamed on Series of Bad Moves

When H. C. Smith bought an oil-tool company in Compton in 1936, oil prices had plunged to 10 cents a barrel and other drill makers were going broke. But Smith, a second generation blacksmith, was undaunted.

Smith invested in more-modern equipment, developed new products and experimented with unusual tool designs. And in World War II when oil conservation measures halted drilling, Smith stamped out war supplies, such as combat rockets and landing gear struts. The point was to keep his company alive.

Decades later, Smith International in Newport Beach, Smith’s legacy and the world’s second-largest manufacturer of drill bits, is confronting yet another plunge in oil prices and declining demand for oil-drilling tools. And again the company is fighting for survival.

Yet, this time, analysts say, the likelihood of success appears remote.

Although the entire oil industry is suffering through one of the steepest declines in oil prices and drilling activity in recent decades, Smith is the only major oil-tool manufacturer facing the prospect of collapse.

Huge Damage Award

The immediate cause of Smith’s precarious position is the $207-million patent infringement award the company was ordered to pay Hughes Tool Co. two weeks ago, a judgment that company officials acknowledge may put it in default on $260 million worth of loans.

However, some analysts contend that Smith would have been better able to handle such a devastating decision if it had not frittered away its assets and energies on what turned out to be ill-advised moves and strategies.

“The slide is almost irreversible at this time,” said Jeff Freedman, an analyst with Smith Barney, Harris Upham & Co. in New York. “Chapter 11 (bankruptcy reorganization) is a realistic possibility.”

Sources both in and outside the company say Smith is seriously considering the possibility of filing for bankruptcy and has hired an attorney to explore that option, while it continues to look for other solutions.

Part of Smith’s problems, analysts say, stems from Smith’s historic concentration on the domestic oil-drilling market, which has fallen even more sharply than the foreign market. It also failed to introduce a labor-saving, high-technology product line.

In addition, former top-ranking employees point to the company’s failure to ax its money-losing operations fast enough when the oil market started dropping in 1982. In 1983 and 1984, the company was forced to take pretax write-offs and write-downs totaling $273 million. Losses between January, 1983, and October, 1985, add up to $221 million and most analysts declined to even speculate what the losses might be for the final quarter of 1985.

All blame the company’s corporate executives for poor decision-making.

However, the single largest reason for Smith problems, employees and analysts agree, was the company’s expensive, time-consuming and, ultimately, thwarted attempt to acquire Gearhart Industries Inc.

Analysts and employees blame the Gearhart misjudgment on Jerry Neely, son-in-law of H. C. Smith who died in 1967.

Neely, now 48, joined the company in 1965 and has been its chief executive officer since 1976. According to the most recent proxy statement, Neely received a salary of $400,000 and a bonus of $160,200 in 1984, the year the company lost $68.4 million.

Neely refused to discuss the company’s plight or its options with The Times, saying he is legally restricted from doing so and is “very busy trying to deal with” the court decision on the Hughes patent. Beside, Neely added, “If you have problems on top of a bad economy, it makes it very difficult.”

Mention of Neely’s marriage is frequently used to preface comments about his professional performance. “Jerry hasn’t done an appallingly bad job,” said one analyst who asked to remain unidentified. “But it’s generally recognized in the industry that Jerry wouldn’t be where he is if he weren’t related to the family.”

Neely, who is often described as a shy administrator who has trouble communicating with his staff, is faulted for his stubborn and extremely costly attempt to acquire Gearhart Industries, but not for the strategy that led to the acquisition attempt.

The original goal of the deal was to incorporate Gearhart’s high-technology devices for detecting the extent and quality of oil and gas resources into Smith’s drilling tools. The concept of acquiring Gearhart was sound business strategy, the analysts say, and would have opened up lucrative new markets and given it a reputation for innovation that the company sorely lacked.

“The strength of the company has been in manufacturing . . . not in high technology and research and development,” said a former top official of one of Smith International’s divisions.

In some ways, Neely was following in the footsteps of his father-in-law, who, according to a company history was always on the lookout for beneficial acquisitions and mergers. At various times in its past, Smith bought companies and founded new divisions to manufacture industrial grating products, parts for space missiles, and drill tools used in the U.S. underground nuclear testing program in Nevada.

But in the case of Gearhart, analysts say that Neely shouldn’t have tried to pressure the smaller company into a shotgun marriage when it became apparent that Gearhart was a reluctant bride.

“If Gearhart had cooperated, it would have been good for both companies, but Smith stuck at it too long once it became obvious it was unfriendly,” said Herb Hart, a consultant with S. G. Warburg, Rowe & Pitman, Akroyd Inc. in San Francisco.

A Smith Tool official who asked not to be identified said “no one at the division level understood” Neely’s behavior regarding Gearhart.

“It didn’t make sense,” he said. “The overall strategy was fine but the price (Smith Tool was paying for Gearhart stock) was high and it was a time in the marketplace when things were deteriorating.”

He added: “It got to be an ego struggle” between Neely, who wanted to acquire Gearhart, and Marvin Gearhart, chairman of Gearhart, who didn’t want to lose control of the company he had created.

In the end, Smith and Gearhart in March of last year announced a settlement whereby Smith sold off the 33% interest it had acquired in Gearhart, for which Smith received only about half of the $163 million it had paid for the Gearhart stock.

James Carroll, a securities analyst with Paine Webber Mitchell Hutchins, said he believes that Smith would not be better off today even if it had been able to acquire Gearhart because it would have been burdened with a huge financing debt.

“It would have been better if they never did anything at all (about acquiring Gearhart),” he said, noting that the approximately $80 million that Smith lost in the Gearhart debacle “would have gone a long way to offset potential damages from the Hughes litigation.”

Freedman, of Smith Barney, said: “The Gearhart deal cost the company its life. Smith could have weathered the downturn in the oil business and the Hughes settlement if it weren’t for Gearhart. Neely should have cut his losses earlier.”

Marvin Gearhart also criticized the Neely management group’s performance. “The team that’s running Smith isn’t the team that built it,” he said. “If the old timers were still there, the company wouldn’t be in the trouble it is in now.”

The troubles that Smith faces these days started in 1982, when the oil crisis turned from one of undersupply to one of growing oversupply. Exploration rigs, which numbered about 4,000 at their peak in 1980, now total less than 1,300 in the United States, Smith’s primary market. Some analysts project that the count could drop to even 1,000 by the end of the year.

Against the backdrop of a declining world oil market, Smith made a series of cuts in its work force and periodically reorganized its operating divisions. Insiders estimate that the company easily spent $1 million for management consulting services to aid it in its repeated reorganizations, acquisitions and divestitures over the last four years.

Between December, 1981, and December, 1984, companywide employment dropped 31%, from 12,853 to 8,900 workers and additional cuts were made throughout 1985, leaving the total at about 6,000, according to company sources. And although the company officially is keeping under wraps the extent of the latest cuts, several former high-ranking employees say that about 2,000 more workers worldwide will be let go.

At the Irvine-based Smith Tool division, the heart of Smith International, morale has sunk. Within less than a month, the division’s work force has shrunk by more than 60% from 1,750 to about 690 workers. Vice presidents as well as production workers are numbered among the casualties.

Also, Smith Tool has announced that it is consolidating two of its Houston divisions, Drilco and Servco, into its Smith Drilling Systems division and that the Tustin-based T.C.M. division will be combined with Smith Tool.

While analysts agree that such cost-cutting measures are warranted in a declining market, some say that they won’t be sufficient to salvage the company in its present form.

Analyst’s Scenario

Yet, James Crandell of Salomon Brothers in New York said ongoing reorganization could create units that might be given to Hughes Tool Company as part of the patent infringement suit settlement. According to Crandell’s scenario, Smith would emerge after the transfer, “a small, weak company” that might make an attractive acquisition candidate.

“It’s going to be tough for Smith to survive as an independent company,” Crandell said.

Smith’s problems today are a far cry from its heydays of just a decade ago. But insiders said some of the seeds of the current problems can be traced to the heady success of the late 1970s.

Current and former Smith executives complained that in the years following Smith’s explosive growth, the corporate office, and particularly Neely, lost touch with its operating divisions.

“In the years I ran the division, Neely came to see us once, and I had virtually no conversations with him,” said one former top division official. “I am unaware of any impact he had on my decisions. Most of the people in the division didn’t even know who he was.”

Another retired division administrator, who worked at Smith for 23 years, recalled that when he joined the company in 1962 it was a “very close-knit, cohesive group” that grew “by dint of hard work” and by being “in the right industry at the right place at the right time.”

The company continued to operate “lean and mean,” he said, until the mid 1970s, when the aftermath of the 1973 Arab oil embargo forced U.S. firms to step up drilling activity to increase national self-sufficiency.

Went to Their Heads

“Then we grew by leaps and bounds and we ended up, quite frankly, with a lot of people who took credit for Smith’s growth when it wasn’t their doing. A lot of people got some big heads and I think that is what started Smith’s problem,” he said.

Some former Smith employees also say that after Smith’s revenues soared, top executives for the first time started spending considerable sums on company cars and other fringe benefits. But the rank and file didn’t complain much, one former employee added, because the company also provided them with generous pension and insurance plans and a very popular stock bonus program. Smith common stock hit a high of $70.25 a share in late 1980. It closed on the New York Stock Exchange Friday at $2.50.

Analyst Hart said that during the heydays Smith wasn’t more extravagant than any other oil-service company, except for its occupancy in 1975 of a posh, three-story, reflecting glass building overlooking a lake in Newport Beach. Last year, as its business shrunk, Smith abandoned the building for one of about half the size.

Of all Smith’s current problems, the repercussions from the Hughes patent dispute is considered by some analysts to have been the least predictable.

Hart said that 14 years ago, when Smith decided to use a drill bit rubber seal similar to that on which Hughes held a patent, it was not an unusual move within the oil industry. “I don’t think anyone would have considered it a particularly heinous crime,” he said. Oil companies often violated one another’s patent rights and, if challenged, agreed to pay the patent holder a license fee, Hart said.

Smith Sued First

However, it was Smith who threw the first gauntlet in the patent suit when it sued Hughes in an attempt to prove that the Hughes patent was invalid. In 1979, a trial court agreed with Smith. However, the decision was reversed by an appeals court in 1982. And on Feb. 14, Judge Harry L. Hupp awarded Hughes an estimated $207 million in damages.

The mammoth pay-out that Smith faces in the patent case is remarkable, too, because Hughes’ patented seal, which prevents the leaking of drill bit lubrication, apparently was never crucial to Smith’s bit business. Hart and several Smith officials noted that Smith devised a replacement for the Hughes seal “within a few months” after the 1982 court ruling and didn’t lose any customers.